Welcome to part two of my blog when and why to sell a stock short which gives a good fundamental analysis of short selling stock.
Short selling strategies
Short selling strategies are used in speculation, hedging, arbitrage and ‘against the box’ strategies. Many investors believe that a good combination of short and long positions on stock is beneficial to your stock portfolio.
The first three strategies are quite simple and i have sourced some definitions from wikipedia below. The final against the box strategy is more interesting and I tried to give a clear outline of it myself:
A seller intentionally takes on the risk of the stock moving up or down in price in the belief that the value of the shorted stock will fall. An example of this is short selling the stock of a company before its earnings reports are released if you believe the reports will fall below the expectations of market analysts.
Short selling often represents a means of minimizing the risk from a more complex set of transactions. Examples of this are:
- A farmer who has just planted his wheat wants to lock in the price at which he can sell after the harvest. He would take a short position in wheat futures.
- A market maker in corporate bonds is constantly trading bonds when clients want to buy or sell. This can create substantial bond positions. The largest risk is that interest rates overall move. The trader can hedge this risk by selling government bonds short against his long positions in corporate bonds. In this way, the risk that remains is credit risk of the corporate bonds.
A short seller may be trying to benefit from market inefficiencies arising from the mispricing of certain products. An example of this is:
- an arbitrageur who buys long futures contracts on a US Treasury security, and sells short the underlying US Treasury security.
Against the box
One variant of selling short involves also using a long position. “Selling short against the box” is defined as holding a long position and entering a short sale order on the same stock.
The purpose of this technique is to lock in the paper profits on the long position collected so far without having to sell that position (and possibly incur taxes if the position has appreciated). Whether prices increase or decrease from this point, the short position balances the long position and the profits are locked in minus the brokerage fees and short financing costs.
The term box alludes to the time when a safe deposit box was used to store (long) shares.